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What is Operational Due Diligence Identifying and assessing non-investment risks for asset managers

Aon | Retirement & Investment

Proprietary & Confidential | May 2017 2

Four Key Areas of Non-Investment Risk

Headline risk

Costs or losses associated with business deterioration Lower level risks that contribute to slippage

Trade errors

Sub-optimal implementation of core or ancillary

processes

Purposeful misappropriation

Collusion

Employee theft

Fraud

Counterparty risk

Asset – Liability mis-match

Inappropriate or poor understanding of leverage

Potential for style drift

Blow-Up

Reputational Alpha Degeneration

“50% of all hedge fund failures are related to operational

failures.”



How Operations and Operational Due Diligence are evolving



Evolution of Operations… and Operational Due Diligence

2005 2017

Half of all hedge fund

failures are related to

operational failures

Are half of all hedge

fund failures are related

to operational failures

any longer?



Evolution of Operations… and Operational Due Diligence

Pre – Madoff Post - Madoff Current Environment

Operations

Limited regulation

Nascent technology

Internal administration

ODD

Best practice:

Comprehensive ODD

Focus on hedge funds

Operations

Increasing regulation

Developing technology

External administration

ODD

Market practice:

Comprehensive ODD on

hedge funds

Best practice: Attention

to other asset classes

Operations

Material increase in regulation

Straight through processing

External administration

ODD

Best practice: Comprehensive

ODD on all asset classes

2005 2017



What is Operational Due Diligence



Audience Question:

“50% of all hedge fund failures are related to operational failures.”

What are the biggest non-

investment risks faced by asset

managers today?



What is Operational Due Diligence?

Topics we cover

Corporate and

Organizational

Structure

Trade and

Transaction

Execution

Middle/Back

Office and

Valuation

Investment and

Counterparty

Risk Oversight

Compliance

and

Audit/Testing

Technology and

Business

Continuity

Key Service

Providers

Fund Structure

and

Administration




Topics we cover: Key Areas

Corporate Structure – control, decision making, and

oversight

Organizational Structure – segregation of duties and

staffing adequacy/competency

Key person exposure and succession planning

Employee Retention and Turnover

Background checks

Corporate and

Organizational

Structure




Topics we cover: Getting in the Weeds

Corporate and

Organizational

Structure

1. Compliance can trade and actively does

2. Complete absence of background checking (in most scenarios)

3. Historical/pending regulatory or litigation issues that are material

4. Senior non-investment functional heads that are clearly not skilled, experienced, or empowered

5. Going concern risks sufficient to cause involuntary liquidation (profitability, contingent liabilities, litigation, regulation issues)

6. Under resourced control or support functions; inadequate compliance or finance functions as exhibited by minimal staff

7. Gut or similar cues whether onsite (empty desks, noticeable disarray, nervousness, etc.) or desk-side/pre onsite (lack of

transparency)

8. Significant turnover among firm Board of Directors members (if applicable)

9. Absentee controlling shareholder with limited expertise, conflicting business activities, etc.

10. Manager / fund(s) set up in a jurisdiction that is not highly regulated or unusual location without reasonable business

support (eg, UK manager running a fund in Brazil)

11. Segregation of duties issues that are less severe (CFO is CCO, trading is segregated by employee but reports through

operations, CCO reports to COO rather than CEO, CEO has investment responsibilities)

12. Individual has multiple roles that challenge ability to conduct each/all of them effectively (COO is also CCO and head of

HR) or with appropriate level of skill/competence.

13. Lack of appropriate representation on the committees (cross functional for example)

14. Lack of committee meeting consistency

15. Material firm level/firm-wide initiatives (changes in ownership, senior leadership changes, re-locations, systems, etc.)

16. Other org chart deviations or inhibitive reporting lines or backgrounds (say, IT reports through investment team or head of

ops/risk is a former investment professional)

17. Limitations in background checking (not all personnel, no recurring checks, etc.)

18. Concentrated decision making (lack of committee structure; majority owner/controller of firm)

19. Limitations in firm external oversight or governance (lack of independent oversight, particularly in a firm that is not private)

20. Overly complex legal structure- jurisdictional mismatch

21. Key Person risk, particularly when combined with lack of succession planning (functional or control)

22. Limited employee turnover (less senior level)

23. Client concentration

24. Other Employee turnover issues or lack of tracking/spikes in turnover

25. Inappropriate levels/lack of insurance (currently Yes/No)

26. Rapid growth or decline in assets, product extensions, etc., (even if well supported) but especially if not well supported.

27. Inconsistent employee compensation or review process

28. Trading occurs in offices or at times when operations/compliance/risk management personnel or guidelines are not

present/available

29. Recent inception date; no operating history

30. Isolation of staff / multiple locations (i.e. compliance and ops team in a diff building to the IM team)



Audience Question:

“50% of all hedge fund failures are related to operational failures.”

How do we determine what is

“riskier”?



What is Operational Due Diligence … Not?

Investment

Diligence Audit

Legal

Review



The 3 “A’s” of operational risk gaps

Affordability Aptitude Attitude



Things we’ve heard in ODD reviews

“Cyber security is not a

big threat for us”

“We’re too small”

“We don’t like to

meddle”

“Our data has not

backed up in months”

“Don’t want to

slow down our

decision-making”

“We’re not an

enterprise”

Affordability Aptitude Attitude



Aon Hewitt’s Operational Due Diligence Program



Overview of Aon Hewitt’s Operational Due Diligence Team

Team of specialists

responsible for ODD

All new managers and/or

products reviewed

Authority to veto based on

operational risk concerns

Written responses to DDQs

Supporting documentation

Interviews

Service providers

Process demonstrations

Our Operational Due

Diligence (ODD) process

is a multi-faceted review of

Team of 10

Experienced, senior professionals

Supported by data gathering and

processing team

Global Operational

Due Diligence Team Capabilities



Examples of Failing ODD Grades

Failing Rating: Material operational concerns that introduce the potential for

economic or reputational exposure; we recommend that investors do not invest

and/or divest current holdings.



Fixed Income Manager – Fail Rating

Manager profile

Small, 20-person firm running

several billion in traditional

equity and fixed income

strategies

Majority owned by employees;

Private equity firm maintains a

minority stake

Low trade volume

Risks Identified

Organizational Structure

Chief Operating Officer (‘COO’) also PM

Trading and operations report to the COO

COO married to another PM

CFO also reports to the COO

Manual Processes

Traders utilize physical (paper) trade tickets

Handwritten allocations

Trade information entered by operations personnel

Portfolio manager codes mandate restrictions

Technology Infrastructure

4 – 6 week recovery of electronic trading capabilities



Hedge Fund Manager – Fail Rating

Manager profile


several hundred million in

traditional equity and long-

short equity strategies

Recent regional expansion to

Asian market

Privately owned

Risks Identified

Organizational Structure

Back up trader does settlement and investor reporting

Traders report through operations

PM for Asian office is also the local compliance officer

Technology and Cyber Security

“Pre-trade” compliance is implemented post execution.

No password changes or complexity requirements

Remote access without secondary authentication

No penetration test of network.

Fund Governance and Administration

No independent governance

No external review of cash movements



Examples of Conditional Pass ODD Grades

Conditional Pass Rating: Specific operational concerns that the firm has

agreed to address in a reasonable timeframe; upon resolution, AH will review the

firm’s rating.



Real Estate Manager – Conditional Pass Rating

Manager profile


several hundred million private

real estate, managed in

closed-end funds with multi-

year lock-ups

Privately owned, equally by

employees and a large

external corporate parent

company

Strengths

Appropriately leverages corporate parent, including

governance structures and internal audit

Highly diversified decision making structure

Outsources fund administration

Risks Identified

No use of LPAC for funds

All commingled investment funds should have some

level of independent oversight



Fixed Income Strategy – Conditional Pass Rating

Manager profile

Large, multi-national

investment firm of nearly 3000

employees.

Managing several hundred

billion, primarily in traditional

strategies

Publicly traded company

Low trade volume strategy

Strengths

Large, global financial services firm with operations and

controls infrastructure that generally supports a firm of

its profile.

Risks Identified

Specialty strategy not subject to the same levels of

control and oversight (as well as operational expertise)

of firm’s core business:

— Operations analyst is also an authorized trader

— Ability to trade with new dealers and to authorize

new trading relationships without review by others.

— Manual monitoring of guideline compliance



Some current challenges

ODD as Audit

Support

ODD has gotten broader in scope, but has it gotten better?

Resource commitments to core versus non-core risks

Private markets standards lag

— Internal administration

— Limited regulation

— Seller’s market mentality

What is riskier?

— Example: Internal administration vs. password changes

Risk tolerance differences

— Client or asset class

Lagging Asset

Classes

Relative Risk

Assessment



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amendments hereto.

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accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute

accounting, legal, and tax advice and is based on AHIC’s understanding of current laws and interpretation.

This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or

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